What Would Alexander Hamilton Have Done in the Debt Crisis? Financial Historian Richard Sylla on the Debt Ceiling
Were the doomsayers correct about the consequences of a default?
I don’t think the doomsayers were correct, but on the other hand it would’ve been a bad thing to have happen. I always like to point out to people that the U.S. government hasn’t defaulted on payments it was supposed to make, especially debt payments, since the days of Alexander Hamilton in 1790-1791. And that’s actually how we’ve managed to build our sterling reputation as the place where, when everything else is falling apart you want a safe place to put your money, you put it into the U.S. national debt because it’s a big, liquid market with a two hundred twenty year history of not missing a payment. So we’ve managed to threaten our reputation. I think the short-run damage of a default—though it seems unlikely as of Sunday evening, with reports of a deal in the media—won’t be very great, but the long-term damage of our reputation as a country that’s financially trustworthy is where the problem will come. What it means is that the U.S. government, and for that matter all the rest of us, may have to pay a higher interest rate whenever we have to borrow money in the future.
There’s only one alternative to the dollar as a global reserve currency, and that’s the euro. Given the crisis in Europe and the consequential instability in the euro, it has been suggested by some economists and pundits that we really don’t have to fear other economic powers—China, specifically—attempting to move away from the dollar. Thoughts?
Well, I agree with that. I think that’s why there will not be much real damage in the short-term if we ever have a default. If you’re the Chinese government, holding some $1.5 trillion in U.S. government debt, you don’t really have much of another place to go. Europe is shaky now, you can’t take all that money and put it into Swiss francs—the Swiss franc is one of the world’s stable currencies—but Switzerland’s too small, it hasn’t issued enough liabilities for other people to buy. So it’s sort of true that the Chinese don’t have much choice, but that’s not really an excuse for the United States to be irresponsible.
Let’s go back to the historical example. You mentioned Alexander Hamilton in 1790. Can you give us an idea of what happened then? There’s been a lot of rhetoric saying the U.S. government has never defaulted before, but as you said there was a financial crisis that was really at the foundation—
Well, sure. There was a crisis in the 1780s. We shouldn’t say the U.S. has never defaulted, because it was basically in default all throughout the 1780s when the government under the Articles of Confederation had borrowed a lot of money to prosecute the War of Independence. It didn’t have any revenue authority, so it couldn’t pay its debts after the war, and so the debts were basically unserviced and in default throughout the 1780s. That included the domestic debt, and it also included the foreign debt. So when Hamilton came in, he reorganized the whole debt and basically created the modern government bond market by hauling in the old securities and exchanging them for three new security issues: a six percent bond, a three percent bond, and a six percent deferred bond. These were nice firm securities on which he promised to pay principle and interest in hard money or hard money equivalents. In 1790, after he created the modern treasury debt market, which has been going from that time to now (it started out at $63 million and now it is $14 trillion), there was a financial crisis.
I like to think about the crisis of 1792 in particular in the current context, because a rather dramatic thing happened. In the space of two weeks in March of 1792, the market value of the U.S. debt fell by 25 percent. I don’t think anything like that would happen now, but it should remind all of us that when financial crisis occurs, dramatic things can happen. The equivalent of a 25 percent drop in the value of the U.S. debt today would be something like $3.5 trillion—more money than was lost in all of the mortgage mess in the recent financial crisis.
How was that debt devalued in 1792?
Basically, there was speculation going on beforehand (as often happens in a financial crisis). The debt and other assets were rising in value, and we know now that there was a speculative cabal led by one William Duer that was trying to corner the market in the U.S. six percent securities, because these could be use for stock in the Bank of the United States.
The bank was another brand-new innovation of Hamilton’s that came to market in 1791, and people could pay for their stock in the Bank of the United States spread out over a couple years’ time. Hamilton designed it so you could buy some government bonds and use those to pay your payments for your shares in the Bank of the United States. So Duer, knowing that people were buying these bonds, tried to buy up most of them. He borrowed money right and left, and the panic occurred when he defaulted on his debts. He had borrowed so much money from other people that when he defaulted, other people feared they would lose everything. It led to panic selling on Wall Street and in Boston and in Philadelphia. The price of the six percent bond fell from 125 percent of par on March 7, 1792 to about 95 percent of par two weeks later, dropping 30 points.
Hamilton handled the crisis beautifully—in fact, he behaved like a modern central banker in this crisis. The reason most people haven’t ever heard about it is that he did such a good job of handling the crisis that it blew over rather quickly and didn’t become something like 1929-1933 or 2007-2009.
Incidentally, I co-wrote an article about the 1792 crisis, along with Robert E. Wright and David J. Cowen, in the spring 2009 issue of Business History Review.
And so the endgame of this was the reduction of the U.S. debt by 25 percent—
In the market value.
In the market value. Looking at the broad scope of American history, how has the government managed other financial crises in the past? Say, for example, in the 1830s.
Well, in the 1830s Jackson paid off the U.S. national debt. By 1836 we were debt-free. That was quite an achievement. Very few countries in the history of the world have managed to pay all of their debts, and the U.S. is one of them.
It didn’t last very long, though, because a financial crisis hit in 1837. This led to a problem with surpluses. The national debt was paid off, but the national government had more money coming in revenue than it had in expenditures. They decided to rebate it to the states, a sort of revenue sharing. And in 1837, a couple of payments were made to the states, but then the fiscal situation turned around as the result of the financial panic, and these payments top the states stopped.
From that time on, the U.S. government hasn’t been out of debt.
Now, some of these payments led the states to borrow lots of money, and the real fiscal crisis of the Jacksonian era was the bank failures—the panic of 1837—but also in 1841 and 1842 nine U.S. states defaulted on their debt. That created a problem for them, but it also created a problem for the federal government, because some congressmen came in, especially from states that defaulted, and asked for a federal bailout. Congress debated that, and decided not to bail out the states. The states were left to work out arrangements with their creditors. Most of them did that, and most of them got back in the good graces of their creditors. A few, though, like Arkansas and Mississippi, actually defaulted and repudiated their debts. They had a bad reputation for a long time, because they got out of it on technicalities. They claimed the debts were never legitimate in the first place.
But the difference between the 1830s and 1840s and bailing out states like Arkansas, or rather letting states like Arkansas default, and California… California is what, the sixth-largest economy in the world?
That’s right. It would be difficult to bail California out. The U.S. government could do it, but it might set a bad precedent. The states are supposed to be fiscally responsible, as is the federal government. It creates what we economists call a moral hazard. If you bail somebody out, and they say we’ll just be bailed out the next time so we’ll just get back to our bad old ways of spending more than we take in and borrowing, and eventually the federal government will bail us out, that’s a moral hazard.
And that’s why TARP was so politically toxic, because of the message that it send both to businesses and voters.
Yeah, we talk about banks that are too big to fail, and we did in fact bail out some big ones, so that creates a moral hazard. I think the Dodd-Frank Act was an attempt to defuse that moral hazard, but so far it’s not clear that it has done that.
Since the indications are that the immediate moment of crisis has passed, what happens?
Well, now that the reports are that the ceiling will be raised, it’s business as usual, because the ceiling has been raised before. The debt ceilings first came on in the 1940s and there’ve been many cases of the debt ceiling being raised in the past. If we raise the ceiling now, we’re sort of off the hook for a while. But that’s like a temporary reprieve, because the long-term debt situation of the U.S. is really worse than you’d think.
The real problem is, if you factor in the future outlays that have been promised for Social Security and Medicare, these are terribly financed over the next ten, twenty, thirty, forty years. And if we consider that as part of the national debt, the debt’s really quite a bit bigger than the $14 trillion.
The debt ceiling increase now is a short-run solution to a short-run problem. It doesn’t really get at the long-run problem that’s out there, and that’s going to require some sort of thoughtful cutting back on entitlement programs, perhaps revenue increases. I think this will happen over the coming years, but right now the political situation is such that we can’t seem to make much progress on it with the divided government in Washington. But there’s an election next year, and there are elections every two years. That’ll probably result in a change where we’ll get away from this ideologically-charged debate that’s going on in Washington right now, where people sign pledges not to allow any tax increases… We’ll have to behave more like adults about our situation and come up with adult solutions, not ideological posturing.